Every so often, stocks do something unexpected: They go down
instead of up. For neophyte investors, memories of the last bear
market (in 1994) may not be part of their memory banks. More
experienced investors may recall 1990 as a dismal way to begin the
last decade of the century. Few investors and perhaps almost as few
money managers can recall the battering that stocks took in the
ugly 1970s market. But no matter what your frame of reference is,
to have a fighting chance of reaching your financial goals, you
should put your money into more than one investment class.

Smart investors know diversification is the one-two punch that
can help secure long-term financial success. These days, everyone
is an investment expert, from the CNBC gurus to your barber who
dabbles in the market. Their advice runs the gamut from highly
sophisticated portfolio management and asset allocation models to a
basic diversified portfolio. Some strategies are easy to
understand, while others defy all logic. Municipal bonds, for
example, may have a place in investors' portfolios, but often,
these special debt securities aren't recognized for the jewels
they are. The question is, Why municipal bonds now?

Lorayne Fiorillo is a financial advisor at Prudential
Securities. All figures are courtesy of Prudential and are as of
February 6, 1998. Past performance is no guarantee of future
returns. For more information, write to Lorayne in care of
Entrepreneur, 2392 Morse Ave., Irvine, CA 92614.

Put Up Your Dukes

At first glance, "munis" may not seem so attractive.
Interest rates are low on taxable investments. In fact, you can get
the same rate of return from short-term investments that you can
get on a tax-free bond, and money markets don't make you tie up
your money. So what's the fascination with municipal bonds?

First and definitely foremost, that "low interest
rate" you may have seen advertised can be deceptive. Interest
from municipal bonds is generally free from state and federal
taxes, provided you buy bonds issued by your state of residence.
Exceptions include Illinois, Iowa and Kansas, where state taxes are
charged on interest, and Florida, Nevada and Texas, which levy no
state or local income taxes. While interest is tax-free, capital
gains on the sale of the bonds are subject to tax. Income for some
investors may also be subject to the federal Alternative Minimum
Tax, so consult your tax and financial advisors before you
invest.

Many investors are turned off by municipal bonds because of
their paltry yields. After all, why invest in a AAA-rated 30-year
municipal bond paying only 5.25 percent when you can purchase a
Treasury bond of the same maturity yielding 6.13 percent? You
don't have to be a rocket scientist to figure that one
out . . . or do you? Financial advisors are
fond of saying it's not what you make on an investment,
it's what you keep. Let's compare the two aforementioned
investments after federal taxes, considering a 30-year AAA-rated
insured municipal bond yielding 5.25 percent vs. a 30-year Treasury
bond yielding 6.13 percent.

Taxable equivalent yields:

An investor in the 39.6 percent federal tax bracket: 8.69
percent

The 36 percent tax bracket: 8.2 percent

The 31 percent tax bracket: 7.61 percent

The 28 percent tax bracket: 7.29 percent

The winner and heavyweight champion? You guessed it: For
high-income investors, municipal bonds generally provide better
after-tax returns. The secret is to look beyond the initial coupon
at the after-tax yield before you shy away from municipal
bonds.

You Can Still Be A Contender

Today's tax-exempt municipal market and America's
changing demographics give investors a chance to get in on the
municipal bond market. Remember the old supply-and-demand rule?
When demand exceeds supply, prices begin to rise until consumers
are no longer willing to pay the asking price. This principle
applies whether you're talking about groceries, cars, or stocks
and bonds. Let's look at both sides of the equation.

On the demand side, consider the baby boomers, which account for
nearly one-third of all Americans. Whenever the boomers arrive on
the scene, they increase demand. First it was the diaper industry,
then they flooded the school system. As the boomers head toward
retirement, they'll continue to dominate the scene.

The first of the boomers will reach age 65 in 2011. As investors
age, many increase the percentage of their portfolios in
fixed-income investments; boomers will probably be no exception.
While many kinds of fixed-income investments are available, only
municipal bonds offer the exemption from taxes that these retiring
investors could use to maximize their after-tax returns. Unlike
previous generations, the boomers are expected to have accumulated
more wealth than any preceding generation and may invest in
municipal bonds in droves, sharply increasing demand.

On the supply side of the equation, consider the municipal
market itself. The available supply of tax-exempt municipal bonds
has been shrinking in recent years. In the three-year period ending
in 1996, new municipal financings totaled approximately $603.4
billion, while bond redemptions totaled $875.5 billion. This means
that $248.2 billion worth of municipal bonds disappeared from the
marketplace during this three-year period. Taxpayers have also
become reluctant to pass bond referendums, so no one is expecting a
rash of new financings in the near future. Market analysts predict
that new issuance will remain relatively constant, in the $190
billion to $200 billion per-year range, over the next several
years.

What does this mean to investors? The potentially growing demand
and shrinking supply should result in municipal bonds trading at
higher relative prices than we're currently experiencing. Over
the past 15 years, yields on municipals (measured by the 20-year
Bond Buyer Index) have ranged from 77 percent to 86 percent of the
30-year Treasury bond. If demand from baby boomers sparks the
municipal market, the relationship between munis and Treasuries
could move into the 70 percent range. Today's municipal buyers
could have a tax-free, interest-paying, highly demanded investment
on their hands. And at these projected levels, munis would still be
attractive to anyone in the 28 percent or higher federal tax
bracket. One catch: They won't be as attractive as they are
today at an 83 percent-plus relationship.

It's All In The Footwork

Where should investors look for the best values in today's
municipal market? Bubba Bennett, senior vice president and director
of national fixed income marketing at Prudential Securities,
suggests investors consider bonds that will mature in the next six
to 15 years. "The best part of the yield curve is the six- to
15-year range. Beyond 15 years, the curve is flat," says
Bennett, and investors won't make much more for an increased
risk. He gives this example: If a 30-year AAA-rated municipal bond
yields about 5.1 percent, a 10-year bond with the same rating
yields about 4.35 percent. Investors in the 10-year maturity would
get 85 percent of the yield of the 30-year bond, but they would
experience much less volatility. Because yields and market values
fluctuate, an investment sold before maturity may be worth more or
less than its original cost.

Another area Bennett suggests investors check out is the insured
municipal market. Here, issuers with poor credit quality buy
insurance that guarantees the timely return of investors'
principle and interest. Bonds will carry a AAA rating by
Moody's and Standard & Poor's. When yields on 10-year
AAA-rated insured bonds are about 4.45 percent, yields on A-rated
munis of the same maturity are usually about 4.6 percent. Although
this relationship is subject to change, and there's nothing
wrong with an A-rated bond, why take the additional risk for only
15 basis points?

If stocks do experience a bear market or, at the very least, a
temporary pullback in the near future, municipal bonds can provide
a safe haven to protect your profits. A mixture of stocks and bonds
has generally proved to be more efficient in the long run than a
portfolio of only stocks or bonds. Stocks can provide growth at the
expense of volatility, while bonds offer income along with relative
credit safety and return of principal. Together, they can provide a
knockout team of investments.